INVESTMENT QUARTERLY

Bond investors face a reckoning as interest rates jump

Higher rates devalue fixed-income securities, which could be a shock for investors who bought bonds for safety.

The last month was a warning of how volatile the bond market could become. (Andrew Harrer, Bloomberg…)

Wall Street has preferred to call the recent rebound in long-term interest rates a "wake-up call."

But to some bond investors it's apparently more like a five-alarm fire.

As rising interest rates have pushed down the value of older bonds in the last two months, the share prices of popular bond mutual funds have slumped.

Case in point: Shares of the Pimco Total Return Bond fund have dropped 6.4% since May 2.

The losses aren't on the scale of what happened to stocks in 2008-09, when that market plunged nearly 50% in six months. But after years of viewing bonds as a haven, investors suddenly are reconsidering.

Outflows have rocked other bond funds as well. In turn, that has left remaining investors wondering whether the sellers are prescient sentinels or just panicked lemmings.

What troubles many bond owners isn't the rise in interest rates so far, but the risk that the U.S. could be facing a sustained uptrend.

An entire generation of Americans has only known falling rates: Long-term bond yields have mostly been declining for 30 years — which means the value of bond portfolios has mostly been rising for that long.

Over the last 14 years, the average taxable bond fund has had positive total returns every year except 2008. And money has poured in: Total U.S. bond fund assets have nearly tripled since 2004, to $3.47 trillion.

Now what? Here's a primer to help bond investors understand the market's recent gyrations and how to evaluate the potential risks and rewards of owning fixed-income securities.

Why have interest rates risen, and why does that make existing bonds fall in value?

The Federal Reserve began warning in mid-May that if the U.S. economy continued to improve the central bank probably would reduce its regular purchases of Treasury and mortgage bonds. Those purchases, ongoing since 2008, have helped keep a lid on long-term interest rates in general.

Some investors and traders reacted by quickly dumping bonds, betting that higher interest rates were inevitable. The selling has driven the yield on the benchmark 10-year Treasury note from 1.63% in early May to 2.74% now. That has pushed up other long-term rates as well, such as on corporate and municipal bonds.

As yields on new bonds rise, the value of most existing bonds falls. The simple reason: If new bonds yield, say, 2.7%, no investor would pay full price for an older bond that yields, say, 2%. So the market price of the older bond must decline, at least initially.

Could interest rates really be in a long-term uptrend now?

If you believe that U.S. and foreign economies will be in better shape a few years from now, it would make sense that rates should rise from current generational lows.

"I think we're in the foothills of a secular rise in interest rates," said Dan Fuss, who has managed money since 1958 and heads the $22-billion Loomis Sayles Bond Fund in Boston.

Bill Gross, who manages the Pimco Total Return bond fund in Newport Beach, agrees that interest rates have seen their lows. But he believes that the latest jump in bond yields has been overdone given the U.S. economy's modest growth rate.

Why did bond yields surge, if all the Fed did was say that it might reduce its bond purchases at some point?

The sell-off highlighted one of the risks posed by the surge of money into bonds since 2008: Inevitably, some of those bond owners will try to "front-run" the Fed and a turn in interest rates. Once selling begins, it can quickly snowball.

"Millions of people think they can get out the door at once," said Tad Rivelle, chief investment officer for bonds at TCW Group in Los Angeles.

The last month was a warning of how volatile the bond market could become.

Does that mean that long-term interest rates could rise dramatically from current levels?

That's possible. But for yields to then stay elevated would most likely require a continuing barrage of strong economic data, or rising inflation, or both.

What's more, the Fed said last month that even if it began to cut back on bond purchases it would be in no hurry to raise its key short-term interest rate. That rate, lately about 0.1%, in effect anchors all other U.S. interest rates.

Jeffrey Gundlach, head of DoubleLine Capital in Los Angeles, told investors in a late-June conference call that he expected Treasury bond yields to fall again between now and year-end. Given rock-bottom short-term rates and low inflation, bond yields have already "risen to a point where the values are pretty compelling," he said.

But if I expect interest rates to gradually move higher over the next few years, why be in bonds at all now?